Editor's Note: This article is part of the Financial Advisor series "How I Solved It." Advisors describe a client with a problem and what they did to help.
When an accountant reached out to this financial advisor to discuss a tax oversight made by a mutual client, the news was grim. The retired couple had under-withheld almost $50,000 in taxes for the first 11 months of the year and was facing interest and penalties.
The accountant mistakenly assumed, based on conversations she’d had with the couple, that they had been withholding enough of their IRA distributions and Social Security benefits when they did their quarterly tax estimates. To correct the oversight and eliminate the interest and penalties associated with the underpayment, she thought the couple should take an additional $50,000 IRA distribution with 100% tax withholding.
Bradley Newman, a CFP with Harrisburg-based Roof Advisory Group, a division of Fort Pitt Capital, thought there had to be a better strategy than raiding their IRA.
He calculated the couple would actually have to withdraw more than $65,000 from the IRA to cover the net $50,000 in taxes due because the additional distribution would be taxed at 24%. The cost of avoiding the tax penalty and interest would have exceeded $15,000 ($65,000 x 24%), he said.
He asked the accountant if she knew how much the penalty and interest would be if the couple wrote a check from their after-tax investments. She replied 8%, which translated into $4,000 ($50,000 x 8%). That would save the couple more than $11,000 and give their IRA assets the potential opportunity of continuing to appreciate.
Taking the additional $65,000 distribution to pay the penalty and interest “kind of becomes like a dog chasing its tail,” said Newman. “The cure is worse than the disease and the solution hurts more than the problem.”
The additional distribution also would’ve pushed his clients into a higher marginal tax bracket, he said.
Upon sharing his analysis with the accountant, she “basically said, ‘I kind of had my accountant blinders on,’” said Newman. The clients were ecstatic about the more cost-effective strategy, he said, and the accountant told them it was Roof Advisory Group’s idea.
To satisfy the $50,000 withholding shortfall, the couple tapped into funds in a joint investment account. The couple was still subject to the penalty because the IRS wants taxpayers to pay taxes as money is earned, said Newman.